Speech
Current Economic Developments in Australia – A Broad Perspective

I welcome this opportunity to mention some developments in Australia of likely interest
to Japanese institutional investors. At the end of the day, you will reach
your own judgments about whether or not to invest in Australia; it is in all
our interests, however, that those judgments be based on current data, not
outdated perceptions.

Australia traditionally calls upon overseas capital to augment its domestic savings
and help finance its investment spending. Using the current account deficit
as a rough measure of the national savings gap, we presently require net capital
inflow of about $US1 billion ($A1½ billion) a month. The terms we have
to pay for that capital – that is, the interest rates and exchange rates
which apply – depend ultimately on our attractiveness to overseas investors.

Japan, of course, runs large current account surpluses and every month has some $US10
billion to invest overseas. Only a relatively small part of that investment
comes to Australia but it represents about 20 per cent of all foreign investment
in Australia.

Until recently, government bond holdings have accounted for a large proportion of
Japanese investment in Australia. This serves to highlight the particular importance
of interest rates and exchange rates to Japanese investors. Curiously, unlike
their American and British counterparts, Japanese investors have shown relatively
little interest in equity investment in Australia, especially portfolio equity
investment.

The lack of interest in equity is perhaps attributable to earlier unfavourable perceptions
of Australia's economic performance. If so, those perceptions are in need
of updating. As Graph 1 shows, share prices in Australia have risen strongly
over the past year; this mainly reflects lower long-term interest rates, and
good profit results and prospects.

Graph 1

As for government bonds, Japanese investors have done nicely from their investments
in Australia over the years. This can be seen from Graph 2, which compares
the cumulative returns, in yen, from investments in government bonds in several
countries since 1985. Over this period, high coupons and large $A capital gains
from falling yields have more than outweighed what, at times, have been unfavourable
currency movements.

Graph 2

The exchange rate of the $A to the yen was fairly steady in a range of 90–110
over the six years to mid-1992. Since then, the $A has depreciated by 28 per
cent against the yen; this is a large fall but it is not out of line with the
falls in some other currencies against the yen over this period.

Falls Against Yen – 30 June 1992 to Present

%

$US

17

DM

21

Canadian $

24

$A

28

£Stg

33

Ultimately, what determines the attractiveness of Australia for Japanese (and other)
investors is the return on investments, whatever form those investments take.
Many factors enter this equation but interest rates and exchange rates are
always prominent, both in themselves and as proxies for broader economic and
political trends.

Central bankers are not in the business of proffering forecasts of interest rates
or exchange rates. I want instead to review recent movements in these rates,
as a focus for discussing economic developments and policies which can have
implications for future rate movements. My bottom line is that the economic
structure of Australia is changing in ways which should be viewed positively
by overseas investors.

Interest Rates

Monetary policy in Australia was tightened in 1988 and 1989, before being eased progressively.
As shown in
Graph 3, the tightening and the easing both occurred somewhat earlier
than in Japan (and most other countries). Since January 1990, overnight interest
rates in Australia have fallen from 18 per cent to 4¾ per cent. Over
the same period, yields on 10 year government bonds have almost halved, from
around 13 per cent to around
6¾ per cent. Similar movements have occurred in Japan but they
have been less marked; as a result, interest rates in the two countries are
much closer than they have been in a long time.

Graph 3

One reason for this is that Australia's inflation rate is back in line with that
in Japan and other traditionally low inflation countries. This can be seen
in Graph 4; it is a major change compared with the 1970s and 1980s, when Australia
was seen as a high inflation country. That perception is now clearly outdated.

Graph 4

We are confident that inflation will be held in check as the economy picks up. While
some ‘one-off’ factors are likely to push the published (or ‘headline’)
rate to 3 per cent or a little higher over the next year, we believe the ‘underlying’
rate will be held around 2 to 3 per cent. This belief reflects several factors,
not least being the determination of the Reserve Bank and the Government to
see that Australia stays in the low inflation league.

They will be assisted in that endeavour by several developments:

First, expectations of future inflation have fallen as actual inflation has
fallen, and these lower expectations are being factored into price and wage
setting behaviour.

Secondly, Australia has become more closely integrated with the international
economy, and more exposed to international competitive forces; this is imposing
extra discipline on wage and price setters.

Thirdly, even before the recent recession and the jump in unemployment to around
11 per cent, changes in wages policy were leading to more moderate wage increases
and closer linkages to productivity improvements – as the black line
in Graph 5 shows, the increases in earnings have been modest for several years
(Graph 5 also shows, incidentally, the sustained decline in the number of
industrial disputes in Australia; this is another feature of the changing
economic landscape).

Graph 5

The reductions in official interest rates over the past three and a half years have
been mainly in response to domestic developments – specifically, to evidence
of declining inflation and sluggish economic recovery. Over the last year or
so, the exchange rate has become more significant in the consideration of interest
rate changes, mainly because of the potential inflationary consequences of
an on-going slump in the $A.

The earlier monetary policy environment is now changing. In particular, the level
of economic activity is looking a little stronger, the ‘headline’
(but not the ‘underlying’) rate of inflation is set to rise, and
the exchange rate is lower. All this suggests that the long phase of reductions
in short-term interest rates is coming to an end.

Exchange Rates

It also brings me to the question of the exchange rate, which is likely to be of
more than passing interest to this audience.

In trade-weighted index (TWI) terms, the $A has depreciated by about 20 per cent
over the past two years. Against the yen, it has fallen by over 30 per cent;
most of this fall occurred over the past year when, as noted earlier, other
currencies too have fallen sharply against the yen.

How should this fall be viewed? Stepping back from day-to-day market gyrations, I
see it as having a large cyclical component, with the potential for some reversal.

Australia's export base is being steadily broadened but rural and resource commodities
still account for two-thirds of total exports of goods and services (compared
with over 70 per cent 10 years ago). It is not surprising, therefore, that
our currency tends to move broadly in line with commodity prices, which in
turn tend to mirror cyclical swings in the world economy.

The close relationship between commodity prices and the trade weighted $A can be
seen in Graph 6. In the second half of the 1980s, when world industrial production
and commodity prices were generally strong, the $A too was generally strong;
so far in the 1990s, when industrial production in OECD countries has declined
and commodity prices have fallen, the $A has drifted down.

Graph 6

It is well known that the Reserve Bank has intervened heavily in the foreign exchange
market on occasions over recent years. In intervening, we have not sought to
hold any particular exchange rate: we have recognised that in a weak world
economic environment it was logical for a commodity exporting country like
Australia to have a lower exchange rate.

What we have sought to do is to counter large and sudden movements which appear to
be triggered more by market rumours than fundamental factors and which, unchecked,
could threaten inflation and other policy objectives. That continues to be
the Bank's approach. To date, we have achieved our objectives with intervention
but, if necessary, we would also use interest rates.

How quickly the world economy recovers is obviously very important for Australia,
and for the $A. Most commentators remain gloomy about the outlook, although
growth in 1994 is generally expected to be somewhat better than in 1993. How
much better will depend in part on policy action (or inaction) in larger economies
like Japan and Germany to achieve faster growth. Eventually, the world economy
will pick up and, as that occurs, the $A also can be expected to recover somewhat.
If history is any guide, that recovery could be quite strong.

The Australian economy is growing at about 2½ to 3 per cent, which is better
than most OECD countries. We need to grow faster than that but it is difficult
to do so in the middle of a world recession. Policy makers in Australia cannot
accelerate the world recovery. What they can do is to get their own house in
order so that Australia can exploit both the limited market opportunities that
presently exist, and the greater opportunities that will come with the eventual
turnabout in the world economy.

This process of renovating and strengthening the Australian economy so that it better
withstands commodity price and other shocks in the future, has been underway
for some time. It is far from completed but good progress is being made. That
story, regrettably, is not understood as fully as it deserves to be –
either inside or outside the country.

I would like, therefore, to emphasise some key points.

The central theme is a major improvement in Australia's international competitiveness.
Several factors stand out here. One is our low inflation and another is the
20 per cent depreciation of the $A (TWI) over the past two years. The fact
that Australia's inflation performance has at least matched that of our
trading partners means that the large nominal depreciation is being translated
into an equally large real depreciation.

The improvement in competitiveness, however, goes much deeper than the recent depreciation
of the $A. It is also being built on important structural changes in all sectors
of the economy.

I have mentioned already developments in the labour market that are leading to more
moderate, productivity-based wage increases. In other markets too, major changes
are occurring – in the markets for goods, and for banking, telecommunications,
transport and other services, including government services. In some areas,
changes need to be pursued further and with greater urgency but our competitiveness
is being enhanced. That is why I believe Australia will remain competitive
even when the $A moves up on the back of stronger world growth and commodity
prices.

The changes are on-going and mutually reinforcing. They reflect deep-seated changes
in attitudes and aspirations in all sections of the community. Above all, they
reflect a growing realisation that Australia must be internationally competitive
if it is to prosper in today's world. They are real changes with profound
implications for Australia, although their significance is lost on those whose
vision is clouded by short-term preoccupations.

Already there is indisputable evidence that these structural changes are creating
a more open and competitive Australian economy. The greater openness is well
illustrated by the sharp rise in both exports and imports relative to national
output. We can see this in Graph 7; the left hand panel of that graph shows
that exports, for example, now represent 20 per cent of output, compared with
about 13 per cent a decade ago.

Graph 7

In a fortunate conjuncture of events, the increased openness of the Australian economy
has coincided with the rapid growth and industrialisation of the Asian region.
This historic change in the pattern of world production and trade has underscored
a major relative shift in Australian export markets from Europe and North America
to Asia. The right hand panel of Graph 7 shows this shift; over 60 per cent
of our merchandise exports now go to Japan and other countries in Asia.

These domestic and international structural changes are altering the composition
of Australia's exports. Graph 8 illustrates the point made earlier about
the dominance of commodity based exports. At the same time, however, tourism,
education and other services have grown rapidly while the most striking feature
has been the growth in exports of high value-added manufactured goods; these
have grown (in volume terms) at an average annual rate of 14 per cent over
the past seven years and now account for more than 15 per cent of total exports.

Graph 8

It is worth mentioning, incidentally, that this growth has occurred against the background
of a substantial reduction in tariff and other assistance available to the
manufacturing sector; the effective rate of assistance has fallen from about
22 per cent in 1984 to less than 15 per cent in 1991. It is continuing to fall.

For the moment, investment growth is the notable absentee in Australia's economic
recovery. This is partly because of the weak domestic and international demand,
and partly because of the focus by businesses on restructuring their balance
sheets. As in other countries, many firms in Australia borrowed extensively
to acquire assets in the late 1980s and have been obliged to reduce their balance
sheets and unwind their debt. Everywhere this balance sheet restructuring is
taking much longer than had been expected, but businesses in Australia appear
to be further along the road than in most countries.

With business profits recovering strongly and share prices rising, the funding conditions
for a recovery in private investment are improving. Banks in Australia also
are over their worst problems and able to respond to stronger demand for business
credit when it emerges. In particular, non-performing loans, which impose heavy
burdens on banks, have been declining. Graph 9 shows that banks' total
non-performing loans declined from a peak of
5.9 per cent of total assets in March 1992 to 3.9 per cent in June 1993.
It shows also that the average risk-weighted capital ratio of Australian banks
reached 10.9 per cent in June, with all banks well above the
8 per cent minimum requirement.

Graph 9

In summary, then, I believe the Australian economy is changing in ways which are
adding flexibility and strength, and preparing the ground for solid and sustainable
future growth.

As always, there are some constraints on growth. For Australia, these ultimately
come down to external constraints in the form of the current account deficit
and foreign debt. The current account deficit in 1993/94 is forecast to be
about 4 per cent of GDP, compared with an average of 5 per cent in the 1980s,
and the
2 to 3 per cent range characteristic of the 1950s and 1960s.

One consequence of running large on-going current account deficits is that we have
to borrow heavily overseas to finance them. This generates a growing external
debt, which has to be serviced.

If the overseas borrowings are invested wisely, and return at least their servicing
costs, this is not a major concern. That has not always been the case in the
past but, overall, servicing foreign debt has not been an unmanageable problem
for Australia. While the net foreign debt has been rising (to almost 43 per
cent of GDP in June 1993), Graph 10 shows that debt service ratios have fallen
significantly in recent years (mainly as a consequence of falling domestic
and international interest rates).

Graph 10

High foreign debt levels do, however, make us vulnerable to major swings in investor
sentiment, for whatever reason. If foreign investors were to become disenchanted
with Australia to the point of ceasing to lend, the policy options would be
both limited and unpleasant. For this reason, the current account deficit needs
ultimately to be lowered relative to GDP.

There are two sides to this. One is that we need to sell more to the world –
which is why current efforts to make Australian industry more competitive cannot
be relaxed.

Secondly, large current account deficits imply a heavy dependence on foreign savings.
Over time, we need to reduce the vulnerability associated with large current
account deficits by raising our national savings.

That is why implementation of the Australian Government's medium-term budget
deficit reduction program is so important. Reductions in the budget deficit
– and the generation of budget surpluses – are the surest and quickest
means of increasing national savings. The Budget now before the Parliament
acknowledges and addresses these linkages; it provides for the budget deficit
to be reduced from a cyclical peak of around
4 per cent of GDP in 1993/94 to around 1 per cent by 1996/97 (see Graph 11).

Graph 11

The important linkages between the budget deficit and other policy objectives are
not universally understood and politicking over particular budget measures
tends to divert attention from them. A lot of criticism recently has been directed
at selected tax increases, even though some revenue enhancing measures are
inevitable if the deficit is to be lowered over time.

The Budget will be debated further in the Parliament over coming weeks. The Government,
which achieved four successive budget surpluses in the late 1980s, knows how
important it is for the deficit to be wound back over the medium term. It is
committed to its program and is confident it will be implemented.

Conclusion

I trust that Japanese institutions will continue to take a keen interest in Australia,
and seek out the investment opportunities which exist. In assessing whether
now is the time to be investing more in Australia, I would suggest that you
take extra care to distinguish cyclical changes from structural changes. In
my view, the structure of the Australian economy is changing in ways which
will create favourable investment opportunities for those prepared to see and
seize them.

At the end of the day you will, as I said earlier, make your own judgments on these
matters; I hope my comments today will help you to make better informed judgments.